Insight

A guide to materiality past, present, and future

A new business imperative

In recent years, many in the business community have accepted, if not fully embraced, the move toward “stakeholder capitalism”: the notion that companies must address the needs of a broader universe of stakeholders beyond shareholders. Additionally, there is increasing evidence that doing so will bestow benefits on the company itself in terms of reputation, risk management, and operational efficiency. Thanks to increasingly vocal institutional investors such as BlackRock and State Street, corporate executives are increasingly understanding that “this ESG stuff” is not going away. Add to that the largest intergenerational transfer of wealth in history and a groundswell of vocal interest in racial and social equity and climate action from a younger generation of talent. It has become clear to anyone paying attention that management of ESG issues is a necessity for any business looking to maintain a competitive foothold.

Integrating ESG factors into corporate strategy and operations—or not—can have a very real impact on a company’s reputation, access to capital, and bottom line.

Understanding that ESG—heretofore sometimes known as “nonfinancial”—issues can have an impact on company performance is only the first step. From the vast and varied world of ESG issues, how does a company decide which issues are most relevant to their financial performance, their stakeholders, their unique positioning in the world?

Enter materiality analysis.

What matters, and why

“We can’t boil the ocean.” We can’t count the times we’ve heard this unfortunately worded statement in reference to the increasingly complex and interconnected array of issues that business leaders face. The question implicit in this statement is: What matters?

One way to answer this fundamental question is through a materiality analysis: an intentional, thoughtful investigation that narrows a broad array of issues that could be important to company and stakeholders into a subset of issues critical to a company’s ability to execute its business strategy.

Origins and evolution

The concept of materiality has existed in many forms since its first appearance in English common law in the 1800s. We at FrameworkESG see materiality, both in definition and in application, as having evolved in three distinct waves.

The first phase of materiality emerged from accounting and legal circles and focused solely on the information needs and interests of one stakeholder group—investors. The commonly accepted definition of materiality, as clarified by the U.S. Supreme Court in 1976[1] and codified by the SEC, is information “to which there is a substantial likelihood that a reasonable investor[2] would attach importance in determining whether to buy or sell the securities.” The notion of materiality was formed to ensure shareholders and potential shareholders had the right information to assess the level of risk involved in investing in a company.

In the past few decades, materiality entered its second evolution. Professionals both within and external to companies who focused on “corporate responsibility” or “sustainability” began to use the exercise to determine the information and performance needs of stakeholders beyond investors. Nearly every leading standards-setter on ESG information has established its own definition of materiality that accounts for perspectives of stakeholders other than investors. As an example, the Corporate Reporting Dialogue (CRD) establishes materiality as “information is that which is reasonably capable of making a difference to the proper evaluation of the issue at hand.” This definition is significant because it has been agreed to by seven leading standards-setters for ESG information, including the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and CDP. Despite expanding to include ESG issues and a broader stakeholder perspective, materiality was still used mainly to guide disclosure and transparency, staying true to its origins in accounting and ESG reporting frameworks.

In the past decade or so, however, company executives began to realize that materiality assessments could be used for a new purpose—performance improvement and strategy setting. Pushed into service by inquisitive stakeholders seeking to understand how companies were addressing those issues identified as material, the materiality analysis and its results gradually began to be seen as the backbone of a strong strategy to manage ESG impacts. Hence, we are currently navigating this third evolution of materiality.

Conversations matter

In this phase, new processes for determining material issues are rapidly evolving. In the past few years, automated processing technologies have emerged that enable a company to quickly generate a list of material issues through natural language processing—artificial intelligence, or AI. SASB standards have also arisen as another compelling framework for identifying material issues. For every sector, SASB standards prescribe a unique and specific set of issues for disclosure based on that sector’s context. While their methodologies differ, both AI tools and SASB standards allow a company to quickly identify a set of material issues with very little effort.

While these tools can and do contribute valuable intelligence to the process, they alone are insufficient to complete an actionable and inclusive materiality assessment. If the process for determining materiality serves as the foundation for a company’s ESG strategy, then these new tools are missing one of the most important elements of setting a strategy: human engagement. Not only does direct engagement with key internal and external stakeholders bring color and specificity to the results, it also assists with securing buy-in across the organization and building relationships with key external stakeholders. If done well, the materiality process should provide valuable, actionable intelligence; set a direction for future strategy; and gain support from key stakeholders.

A trusted partner

We at FrameworkESG have spent nearly two decades helping dozens of companies navigate the evolving landscape of materiality.

We tailor our materiality process to the specific needs of our clients. Our standard materiality process involves a review of the company, industry, and corporate landscape; a series of internal and external conversations; and several verification meetings to ensure the results are actionable for the client. Throughout the process, we maintain open lines of communication and strive to bring our clients and key internal stakeholders along on the journey. Once a materiality assessment is complete, we are available to help our clients interpret, strategize, and implement plans to act on the assessment findings.

Properly guided, a materiality analysis—process and results—should provide everyday utility. It is not merely a thought exercise to be shelved until the next reporting period but a valuable instrument for engaging stakeholders and moving the needle on what matters.

[1] TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). For a history of definitions and use in accounting, see http://www.accountingin.com/accounting-historians-journal/volume-17-number-2/the-development-of-the-judicial-definition-of-materiality/.

[2] As more investors recognize the value of ESG management and the implications on business performance of ESG mismanagement, this definition may come to encompass ESG information. Any “reasonable investor”, per the SEC definition, will consider ESG information essential in making investment decisions. We’ll then enter a fourth phase of materiality, where the lenses of financial materiality and ESG materiality converge.